Team members:

1. Zineb Mouline
2. Lan Yao
3. Cihangir Erdal
*Calculations are shown in blue, and answers are highlighted in yellow

1. Short Questions
1. You will be paid $500 in 6 months and $1,000 in one year. You can invest at 4% (EAR).
EAR 4%
interest rate (6 months) 1.98% (1+4%)^0.5-1
Payment 6months $ 500.00
Payment 1 year $ 1,000.00
investment 80%

(i) If you invest 80% of the money receive (and consume the rest), how much will you have in 4 years from now?

ye ar ly PV at t0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0

6 m o n t h ly PV at t0 6 12 18 24 30 36 42 48
C ash in flo w 490.29 $ 500.00 $573.57
961.54 $ 1,000.00 ###
PV o f C Fs 1,451.83
in ve st m e n t 392.23 $ 400.00 $ 4 5 8 . 8 6 FV1=500*0.8*(1+0.0198)^7
769.23 $ 800.00 $ 8 9 9 . 8 9 FV2=1000*0.8*(1+0.04)^3
PV o f C Fs 1,161.46 # # # Sum of FV1 + FV2

ii) If you want to have $2,000 in 10 years, what fraction of the money you receive do you need to invest?

ye ar ly t0 1 2 3 4 5 6 7 8 9 10
PV o f fu t u r e C F $ 1,351.13 $ 2,000.00
An n u it y $ 166.58 $ 166.58 $ 166.58 $ 166.58 $ 166.58 $ 166.58 $ 166.58 $ 166.58 $ 166.58 $ 166.58

solve X such as X/4%*(1-1/(1+4%)^10) =2000/(1+0.04)^10 X= $ 1 6 6 . 5 8

PV of money received 1451.83
fr ac t io n t o in ve st 93.1%

(iii) Suppose today is September 1st, 2017. If you invest all the money you receive, on which date will you have $2,000?

PV o f m o n e y r e c e ive d $ 1,451.83
Am o u n t r e c e ive d in n pe r io $ 2,000.00
n (ye ar s) 8.17 so lve n su c h (1451.83)*(1+4%)^n=2000
St ar t in g dat e 9/1/2017
date you get $2000 10/30/2025

2. If the annual interest rate is 4%, would you rather An n u al r at e 4%

(a) Receive $200 today and pay $210 in two year.
(b) Pay $200 today and receive $220 in one year.
(c) Receive $100 today and $100 in one year, and pay $206 in two years

0 1 2
(a) $ 200.00
PV o f fu t u r e C F $ -194.16 $ -210.00 PV=-210/(1+4%)^2
su m $ 5.84

0 1
(b) $ -200.00
PV o f fu t u r e C F $ 211.54 $ 220.00 PV=220/(1+4%)
su m $ 11.54

0 1 2
© $ 100.00
PV o f fu t u r e C F $ 96.15 $ 100.00 PV=100/(1+4%)
PV o f fu t u r e C F $ -190.46 $ -206.00 PV=-206/(1+4%)^2
su m $ 5.70

3. If the interest rate is 3%, would you rather An n u al r at e 3%

(a) Receive $100 every year for 10 years starting in one year.
(b) Receive $90 every year for 11 years starting in one year.
(c) Receive $103 every year for 10 years starting in two years

0 1 2 3 4 5 6 7 8 9 10
(a) $ 100.00 $ 100.00 $ 100.00 $ 100.00 $ 100.00 $ 100.00 $ 100.00 $ 100.00 $ 100.00 $ 100.00
PV o f fu t u r e C F $ 853.02
PV=(100/3%)*(1-1/(1+3%)^10)

timeline 0 1 2 3 4 5 6 7 8 9 10 11
(b) $ 90.00 $ 90.00 $ 90.00 $ 90.00 $ 90.00 $ 90.00 $ 90.00 $ 90.00 $ 90.00 $ 90.00 $ 90.00
PV o f fu t u r e C F $ 832.74
PV=(90/3%)*(1-1/(1+3%)^11)

timeline 0 1 2 3 4 5 6 7 8 9 10 11
(c ) $ 103.00 $ 103.00 $ 103.00 $ 103.00 $ 103.00 $ 103.00 $ 103.00 $ 103.00 $ 103.00 $ 103.00
Value of future CF at year 1 $ 8 7 8 . 6 1 Value at t1=(103/3%)*(1-1/(1+3%)^10)
PV o f fu t u r e C F $ 8 5 3 . 0 2 PV = Value t1/(1+3%)

4. If the interest rate is 5%, would you rather An n u al r at e 5%

(a) Receive an perpetuity that increases at 3% per year with a first payment of $100 in five years. growth rate 3%
b) Re c e ive an pe r pe t u it y t h at in c r e ase s at 2 . 5 % pe r ye ar wit h a fir st paym e n t o f $ 1 0 0growth rate 2.5%
c) Receive an perpetuity that increases at 1% per year with a first payment of $160 in one year. growth rate 1%

timeline 0 1 2 3 4 5 6 7 8 9
$ 100.00 $ 103.00 106.09 109.2727 112.55088 etc.
$ 5,000.00
PV of the perpetuity (a) $ 4 , 1 1 4 PV=100/(5%-3%)/(1+5%)^4

$ 100.00 $ 102.50 105.0625 107.6890625 110.3812890625 113.1408212891 etc.

PV of the perpetuity (b) $ 4 , 2 0 0 PV=(100*1.025)/(5%-2.5%)+100

$ 160.00 $ 161.60 163.216 164.84816 166.4966416 etc.

PV of the perpetuity (c) $ 4 , 0 0 0 PV=160/(5%-1%)

Pe r pe t u it y B h as t h e h igh e st PV

5. You take a 10-year mortgage for $200,000 at a 3.90% APR with constant bi-weekly payments. The loan is fully repaid at the end of the 10th year.
i) How much is your bi-weekly payment?
capital $ 200,000 solve Annuity such as X/r(1-1/(1+0.15%)^260)=200,000
APR 3.90% Biweekly paymeX 9 2 6 . 4 2 biwe e kly paym e n t = 2 0 0 0 0 0 / (1 - 1 / (1 + 0 . 1 5 % )^2 6 0 )* 0 . 1 5 %
biweekly interest 0.15% biweekly rate=(1+3.9%)^(1/26)-1
reimbursment period (years) 10
reimbursment period (2weeks) 260

(ii) How much interest will you have paid over the course of 10 years?
Biweekly payments $ 926.42
Payments over 10 years $ 240,869.50 Payment=926.42*260
interests paid $ 4 0 , 8 6 9 . 5 0 Interest=Payment-capital=240869.5-200000

(iii) Would total interest payments have been higher or lower if you had monthly payments instead of bi-weekly ones? (No computation needed)

T o t al in t e r e st paym e n t s will be h igh e r wit h m o n t h ly paym e n t s t h an t h e bi- we e kly paym e n t s. By u sin g t h e r at e c o n ve r sio n fo r m u la 1 + r _m o n t h ly = (1 + r _biwe e kly)^2 bi- we e kly in t e r e st r at e s be c o m e lo we r .
Advan c in g t h e m o n t h ly paym e n t by t wo we e ks o u t o f e ve r y m o n t h , r e du c e s t h e t o t al am o u n t o f in t e r e st yo u h ave t o pay, t h u s m akin g biwe e kly sligh t ly m o r e in t e r e st in g.

Numerical verification:
APR 3.90%
monthly interest 0.32%
monthly payment $2,008.97
over 10 years $241,076.43
interests paid $ 4 1 , 0 7 6 . 4 3 higher

Face Value $ 1,000.00

6. Bond A has a face value of $1,000, zero coupon, 3-year maturity, and trades at $920. Maturity 3
(a) Compute Bond A’s yield to maturity. PV $ 920.00

0 1 2 3
Bo n d A $ 920.00 $ 1,000.00

solve r such as 1000/(1+r)^3=920

Y T M (r ) 2.818%

b) Bond B has face value of $1,000, pays a 5% interest rate (EAR), has 3-year maturity and trades at $1,050. Does bond B have a higher yield to maturity than Bond A?

0 1 2 3 Face Value $ 1,000.00

Annuity $ 50.00 $ 50.00 $ 50.00 Maturity 3
Face Value $ 1,000.00 PV $ 1,050.00
PV $ 1,050.00 EAR 5%

Option 1. solve r such as 50/r*(1-1/(1+r)^3)+1000/(1+r)^3=1050

Option 2. use the YTM of Bond A in Bond B formula and compare PVs
the same YTM as bond A gives a higher PV than the actual PV of the bond B (ie $1050),
T h e r e fo r e t h e Y T M is h igh e r wit h bo n d B.

YTM PV
2.818% $ 1,061.93
Y T M (bo n d B) 3.22% $ 1,050.00

7. Can you find a simple way to compute the present value of a 30-year annuity with a first payment of $100 in one year that grows at 5% per year if the interest rate is 5%?

Each year the growing annuity=100*(1+5%)^n-1 110.25

discounted to PV = 100*(1+5%)^n-1/ (1+5 95.24
For 30 years period = 95.24*30 2,857

2. Saving For college

initial savings $ 10,000
inflation 2%
EAR (nominal) 5%
EAR (real) 2.94%

Investment timeline 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Rose's age 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Ben's age 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Ro se ' s savin g $ 100,000
Be n ' s savin g $ 100,000

PV of Rose's $100,000 6 8 , 6 0 3 PV=100,000/(1+2.94%)^13

PV of Ben's $100,000 6 2 , 8 8 9 PV=100,000/(1+2.94%)^16
Sub_Total 131,492
Existing education fund 10,000
TOTAL PV 1 2 1 , 4 9 2 TOTAL PV=Sub_Total - Existing education Fund
monthly saving 9 , 6 2 9 monthly saving=121.492/(1-1/(1+2.94%)^16)*2.94%

Savings
Age Rose age Ben t real nominal
5 2 0
6 3 1 $ 9,629 $ 9,821 First Payment CF_nom=CF_real*(1+i)^yr
7 4 2 $ 9,629 $ 10,018
8 5 3 $ 9,629 $ 10,218
9 6 4 $ 9,629 $ 10,422
10 7 5 $ 9,629 $ 10,631
11 8 6 $ 9,629 $ 10,843
12 9 7 $ 9,629 $ 11,060
13 10 8 $ 9,629 $ 11,281
14 11 9 $ 9,629 $ 11,507
15 12 10 $ 9,629 $ 11,737
16 13 11 $ 9,629 $ 11,972
17 14 12 $ 9,629 $ 12,211
18 15 13 $ 9,629 $ 12,456
19 16 14 $ 9,629 $ 12,705
20 17 15 $ 9,629 $ 12,959
21 18 16 $ 9,629 $ 13,218 L ast Payment

3. NPV
You are considering a project that requires an immediate investment of $100 million and generates a constant cash-flow of $12 million every year starting next year (forever). The appropriate discount rate is 10%. 1. Should you undertake the project? 2. What is the project’s IRR? 4. Another of your partner suggests that part of the project’s costs could be outsourced. This would eliminate 50% of the initial investment and all of the maintenance investment. However, it would reduce free cash-flows to $6 million per year. Is outsourcing a good solution?

investment $ 100,000,000 NPV(1 ) $ 2 0 , 0 0 0 , 0 0 0 NPV(1)=-100M+(12M/10%)

CF(perpetuity) $ 12,000,000
discount rate 10%

1. Should you undertake the project? Y ES because NPV is positive

2. What is the project’s IRR? 12% > 10% IRR is larger than discount rate, so we should undertake the project.
IRR= C F/ in ve st m e n t = 1 2 M / 1 0 0 M

3. One of your partners points out that this project would actually require maintenance investments of $2 million every second year (first payment in two years).

additional investments $ 2,000,000

converting rate for 2 years investments 1+r(year)=(1+r(2years))^1/2 r (2 ye ar s) 21%
PV o f t h e add $ 9 , 5 2 3 , 8 0 9 . 5 2 PV of the additional CFs=2M/21%
NPV(2) $ 1 0 , 4 7 6 , 1 9 0 . 4 8 NPV(2)=-100M-9523809.52+(12M/10%)

Taking this into account, should you still undertake the project? YES because NPV(2) is positive
4. Another of your partner suggests that part of the project’s costs could be outsourced. This would eliminate 50% of the initial investment and all of the maintenance investment. However, it would reduce free cash-flows to $6 million per year. Is outsourcing a good solution?

NPV(3 ) ¥ 1 0 , 0 0 0 , 0 0 0 NPV(3)=-(100M/2)+(6M/10%)

NPV(3) is < NPV(2), which means the firm is better off keeping the CFs of $12,000,000, eventhough with maintenance costs
oject’s costs could be outsourced. This would eliminate 50% of the initial investment and all of the maintenance investment. However, it would reduce free cash-flows to $6 million per year. Is outsourcing a good solution?